Oil prices staged a furious rally in the second half of 2017, as the price of a barrel of West Texas Intermediate (WTI) crude rebounded from $42 to $60 by year-end. Yet that surge failed to give a boost to shares of energy producers, refiners and transporters.
Now, with the WTI moving even higher, above $70 this spring, the long-anticipated energy sector rally has taken root. The Energy Select Sector SPDR Fund (XLE), for example, slid seven percent from the end of 2016 through March 2018. But since the start of April, it has rebounded an impressive 15 percent. That fund, which carries a 0.13 percent expense ratio and has a category-high $19.6 billion in assets, provides broad-based exposure to the various sub-sectors of energy.
A pair of factors are helping to lift energy stock prices. First, investors no longer fret that the oil price surge is a head fake. “OPEC continues to maintain production limits, and there are questions about supply cuts in places like Venezuela and Iran,” says Matthew Bartolini, head of SPDR Americas Research at State Street Global Advisors (SSGA). He also points to IMF forecasts of global GDP growth of 3.9 percent in 2018 and 2019 as a source of strong demand for oil.
With that backdrop in place, $70 increasingly appears to be the new floor for WTI prices, and not the ceiling.
As another sector positive, oil firms now appear more committed to cash-flow growth than revenue growth. As Del Stafford, head of multi-asset portfolio strategy at BlackRock recently wrote to clients, “unlike in some past oil market rallies, companies are not making huge investments in future production.”
Despite the recent rebound in sector share prices, they still haven’t caught up to underlying crude oil prices. “It is quite remarkable to consider that while oil prices have recovered sector valuations remain heavily discounted at average levels we estimate below $50,” noted Merrill Lynch’s Doug Leggate in a recent note to clients.
One reason for the lag in share prices can be pinned on hedging. Many energy producers agreed to sell oil at locked-in prices when prices were lower. As those hedging deals expire, these firms will start to see sharp improvements in cash flow.
Yet not all subsectors of the energy market are poised to rally higher from here. For example, energy firms that are more squarely focused on natural gas production continue to face tough times as gas prices remain depressed. Gas is often produced as a by-product of oil drilling, and excess gas production has left global markets oversupplied. And oil services equipment firms may not benefit in the current oil price rally as many of their clients are keeping a tighter lid on spending these days.
Restrained spending is, however, providing a clear lift to the nation’s small and mid-cap energy producers, many of which had been sharply out of favor during that last oil price downturn. SSGA’s Bartolini says that these firms were imperiled by relatively high debt levels and low levels of cash flow.
Since then, many of these firms have reduced their debt loads while also seeing a boost to cash flow from firmer energy prices. “These firms clearly have a higher sensitivity to oil prices,” says Bartolini, which is a tailwind instead of a headwind these days. Still, they now appear to be sticking to more constrained spending when it comes to new production, despite higher prices. “That should also keep a lid on supply, helping prices to stay firm” says Brandon Rakszawski, product manager at VanEck ETFs.